Economic Value Added

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At the heart of successful investing is the question of the valuation of assets. It is often possible to make money from low quality assets if they can be bought cheaply enough, and to lose money on good quality assets if the price paid is too high, but identifying the correct price in advance is more easily said than done.

Decisions by investors to buy, sell or hold assets are based on a comparison of the price being asked with the investor’s idea about what the asset is worth.

There are many different ways to investigate what an asset might be worth. A property, for example, might be valued by looking at comparative recent sales, by adding development costs to an estimate of the land value, by discounting future income returns from the property and so on. Often it is wise to use a variety of methods and to be cautious if there is a wide difference between the lowest and highest.

Irrational valuation

Some conclusions about value are drawn rationally, but many are not. On the irrational side, perhaps the most common fallacy is what behavioural economists call “anchoring”; the tendency to derive a number by using another irrelevant but readily available number as a reference point (the “anchor”).

Retailers make good use of this tendency to anchor when they advertise reduced prices in sales. Good merchandising demands that the old price, often crossed out, should appear on price tags as well as the new, lower one. A rational buyer will disregard the old price completely, of course, and only consider whether the new price represents good value for money, but marketers are able to rely on the fact that many customers will anchor on the old, higher price, and conclude, perhaps subconsciously, that the new price represents value that might not exist.

Similarly, anchoring may cause an investor to think that a share that has dropped in price is good value (or vice versa) without much more investigation. If the previous price is used as an anchor, the tendency is to think that a price that is low compared with yesterday’s price is a price that is low compared with “good value”, but that might not be the case at all. The fact that a price has fallen does not mean that it can be expected to return to its previous level at some point. As we know, stocks do not always return to their previous prices. Some continue to fall, and some go into liquidation, disappearing altogether. The price fall has probably occurred for a reason, which usually means that all previous prices, calculated before the change in circumstances, will be out of date and of no relevance. Market participants are re-assessing the intrinsic values of companies continuously, and a well advised investor will also be trying to measure prices against assessments of value which incorporate the most up to date information available. Yesterday’s calculations and prices are of little relevance.

Incidentally, there is evidence that even hard-nosed professional market analysts are not immune to the intrusion of bias and irrationality when assessing value. To a certain extent, that is the reason for the existence of quant programs. By leaving the decisions to computer models, the possibility of human bias is claimed to be removed

Traditional valuation methods

The valuation of listed shares is of particular interest to financial planners, who advise on long term needs, and try to optimise the balance between the investment, longevity and inflation risks that clients face. A large range of financial ratios is available from brokers’ web sites, or in company financial reports, that can help in forming a rational view of the value of a company. These include profitability ratios (eg ROE), liquidity ratios (eg quick ratio), capital adequacy ratios (eg gearing ratio), market ratios (eg P/E), management efficiency ratios (eg debtor turnover) and the bankruptcy predictor, the Altman Z score.

While all these measures can provide valuable insights into a company’s worth, they suffer from the problem that they are mostly derived from past events on a short-term basis while the true values of companies emerge from future events over the long-term.

Of course, the future is unpredictable, but to help to deal with this, in recent years a new measure of company performance has emerged; Economic Value Added.

Economic Value Added (EVA)

EVA measures the difference between the return on a company’s capital and the cost of that capital. In practical terms, EVA is calculated by reducing Net Operating Profits After Taxes (NOPAT) by the total cost of capital, including both debt and equity capital. A positive EVA indicates that value has been created for the owners of the company. Conversely, a negative EVA indicates the destruction of shareholder value.

To see the difference between EVA and more traditional performance measures like net income, take the example of a newly established company called Allen’s After-market Accessories (AAA). The company earns $1,200,000 on a capital base of $10 million thanks to the success of a single imported product line. Traditional accounting would show that AAA offers an above average return on capital of 12%.

However, AAA has only been operating for a short time, and the reliance on a single product line carries significant risk. The lenders to such an enterprise will no doubt charge premium interest rates, and owners will also be looking for higher than average returns. If we assume that in combination these lenders and investors expect 15%, then the EVA calculation will show a loss of value of 3%. So although AAA reports an accounting profit, it has not met the requirements of the providers of capital, and the result has been a reduction in shareholder value.

On the other hand, if AAA were less risky and better established with a cost of capital of 10%, then the same first year operating result would have produced surplus income equal to 2% of capital. That amount would represent an addition to the company’s economic value.

Another way to look at this measure is to consider that the shareholders charge the company rent for tying up their cash to support operations. EVA captures this hidden, opportunity cost of capital that conventional measures miss.

Incidentally, astute readers will notice similarities between this idea of EVA and the controversial “resource rent tax” which initially sought to tax economic “rents”; defined as earnings beyond the risk-free cost of capital.

Calculating EVA

Four steps are involved in calculating EVA. Note that these steps appear to be quite straightforward, but the items on income statements and balance sheets will have been calculated in accordance with traditional accounting standards and methods, and will require many adjustments to achieve a “pure” calculation of EVA.
Step 1: Calculate NOPAT (Net Operating Profits After Tax)
Gross Profits (Sales – Cost of Goods Sold) less Depreciation & Amortisation less Tax.
Step 2: Determine Total Capital Deployed
Net Working Capital + Net Fixed Assets.
Step 3: Calculate WACC (Weighted Average Cost of Capital)
The WACC calculation will take account of the company’s capital structure (proportion of debt and equity on the balance sheet), volatility, and the market risk premium.
Step 4: Calculate Capital Charge to NOPAT & EVA
Total Capital Deployed (Step 2) x Weighted Average Cost of Capital (Step 3)
Economic Value Added will be NOPAT less the Capital Charge.

EVA should help to identify good investments, if calculated consistently. Companies with high EVAs should outperform those with low or negative EVAs over time.

Eva momentum ratio

Arguably, the actual EVA levels matter less than changes in those levels. A positive EVA that is expected to become less positive may be a selling signal, just as a negative EVA that is expected to rise into a positive territory may indicate a “buy”.

The EVA Momentum Ratio compares changes in EVA in a given period to sales in the prior period; in other words, it provides a size adjusted measure of change in EV. For example, if EVA moves from $ 1 million to $ 1.1 million in consecutive years, then EVA in the second period is up by $100,000. If sales in the first period were $5 million, that gives us an EVA Momentum Ratio of 2% ($ 5 million divided by $100,000).

The EVA Momentum Ratio is straightforward and easy to read, yet has many advantages over other common means of establishing value.

  • It consolidates earnings and assets into a single score and automatically corrects for many accounting anomalies in the process
  • It is one of the few measures where an increase is unambiguously a “good thing”. For example, an improved ROC might point to underinvestment in research and development
  • It is scale neutral, enabling comparisons to be made of businesses (or business units) of differing sizes.
  • It is a relative measure of improvement, so will not be distorted when comparing companies starting with a strong platform of brands or infrastructure with others.
  • It is a leading measure, showing improvements or deterioration in shareholder value before the traditional accounts log the profits or losses.
  • It is market calibrated, automatically adjusting for risk, and measuring always against the owners’ expectations.
  • It is difficult to manipulate, as the rules surrounding EVA tend to remove many of the distortions that are embedded in financial statements

It is the job of the management of a business to increase shareholder wealth and EVA is an excellent metric to add to the other indicators of financial performance. Everyone involved in advising on investment in business enterprises should be conversant with EVA.

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